Avoiding Losses
The Idealist Investor
By Sojourner on 01-24-2008
Economists have traditionally conceptualized investment decisions as rational and forward-looking. For example, the amount of money that the person decides to invest and save depends on his or her trajectory of lifetime earnings. However the past decade or so, both economics and finance have explored the intersection of those disciplines with psychology to link emotions such as impatience, regrets and guilt to phenomena such as over-spending and inadequate savings. If a person is perfectly rational, has no change in preferences, and is forward-looking, there is little room for guilt and procrastination which are essentially time-inconsistent emotions. When you look at investment decisions, emotions including fear and envy are definitely driving forces particularly in time of uncertainty and economic hardship. This discussion is timely given the current news of impending economic downturn in the US coupled with existing problems in the banking and credit markets. Many people are wondering about the economic outlook for 2008. What should they do with their assets and money? Emotions are definitely running high. What are some things to watch out for?
In 2002, Daniel Kahneman won the Nobel Prize for his contribution in integrating insights from psychology into economic models for rational decision-making under risk and uncertainty. Particularly, Amos Tversky and Daniel Kahneman were proponents of the concept of “loss aversion”. The theory emphasizes the dichotomy between avoiding losses and acquiring gains. Individuals typically prefer avoiding a $100 loss to making a $100 gain. While the experimental results were mixed, the intuition is that how people view a 5% discount is different from a 5% surcharge. Furthermore, there is an “endowment effect” (or “divestiture aversion”). Particularly, individuals often place a higher value on things they own relative to objects they do not have. These effects reinforce the attachment that individuals experience towards their assets when prices of these assets have fallen below the original purchasing price. It is much more difficult for a house owner or asset holder to part with their assets even though sometimes it may be rational to do so. This is called “status quo bias.” For example, a house owner may decide to put their house on the market to sell out of financial necessity and liquidity constraints but may still knowingly overprice the house even during economic downturn. The house may be vacant for six months as a result and the owner may have to bear the extra cost of lost interest and loan payments, yet there is still the reluctance to lower the selling price. Why? The answer comes back to “loss aversion” and “status quo bias”. Owner of assets prefer to bear a (potentially) higher long term loss than an up-front one-time loss. Indeed this is the irony of the story: the more one has aversion to losses, the more one may have to bear losses due to “loss aversion”. How to avoid this “self-fulfilling prophecy”? Given the bias in judgment brought about by ownership, one way to avoid the bias is to seek outside counsel—a third party’s unbiased view. Ultimately, the question for the owner is whether he or she is able to cut the losses in the event that owning and holding on to status quo is greater than bearing the losses upfront and moving on. I am not recommending individuals to sell their assets right now. In fact, currently it is a buyer’s market in Southern California for real estate. Nevertheless this principle is informative in decision-making in ownership of any type of assets, including stocks, financial instruments or anything that involves costs that are irrecoverable.
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Posted by JackDermody on Jan 24, 2008
Because I used a third party, as Soujourner recommends, my larger pot went into tax free municipal bonds last year. Whew! Keirsey suggests we Idealists have no business messing around with finance. My wife and I are very high on the Idealist spectrum and we are not really kidding when we admit that when we run out of money we just go get more. Guardians find that idea completely incomprehensible. |
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Posted by Pat on Jan 25, 2008
Please, sbeck2001, do NOT try to time this market! The system has gone into oscillation - wild oscillation - around a downward trend line and that is not a good sign. Everybody - PLEASE read "The Bubble that Broke the World" ( a history of 1929-32), "The Great Wave" (price data from the Middle Ages on, charted into what looks like capacitor-discharge waves - we're at the very tail end of one. The 21st Century Equilibrium is in store, but how far down the road?) and "Fourth Turning", which will tell you how far down the road. The only rational thing to do in today's market is (1) ignore all commentators whose 'long view' means running the data Clear! Back! to 1995! They're idiots. Run your data back to 1890, please. This means ignoring your stockbroker and/or financial advisor, too. Unless he's over 90 years old. (2) Go through your portfolio. Ignore stock prices and look at what they do or make. If it's something people can't do without, or (as in the case of hair care products) won't do without, hold. (3) Unless the company is in trouble for fraud and mismanagement. Then sell. (4) A huge number of the financial instruments out there are fraudulent. Some smart guys invented a system of mixing in bad investments with good, layering them, and selling them as good. Finance companies, banks, bond insurers, mortgage companies, they all did it. Finally - if you need any repairs done to your house, car, or yourself (i.e. dental work) and can afford it, do it now. Pay off your debts even if it means living on beans and rice. Downgrade if you have to. We're in for a rough ride. |
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Posted by KipParent on Jan 25, 2008
Pat, I'm curious as to "if you need any repairs done to your house, car, or yourself (i.e. dental work) and can afford it, do it now." What is the reasoning behind this recommendation? Thanks. |
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Posted by Pat on Jan 28, 2008
First, while you can still afford it. If you're working or if your investments are bringing in enough money to pay for these things, do it. If the economy tanks, you may not be able to afford to do so. Second, I'm 69 years old. I'm doing it while I have my health and strength, and while I'm still making my own decisions. The day may come when I can't. Third, it gives me a sense of security to have all these things done. Especially the health-related items: who knows what my HMO and/or Medicare will pay for in the future? I've lived through a number of rule changes and in the last decade everybody's rule seems to have been "IF you can deny a claim or an appeal, do so." |
With the wild gyrations of the stock market these past few days its almost impossible to make "rational" conclusions! If we'd panicked and sold on Tuesday or Wednesday morning, we'd have missed the bounce backs. But its gut wrenching to see these 500 point drops - my IRA is all sitting in the stock market. I try to just figure its a long term deal ("rational"?) and not to worry, but I still lose sleep. How do you recommend I, as an ENFP Idealist, cope?